One way of cashing out business assets involves contributing the business assets to an entity classified for tax purposes as a partnership in exchange for a minority interest in the partnership, where the partnership would borrow money on a full recourse basis and distribute the proceeds of the debt to the contributing partner. The contributing partner would be the sole guarantor of the debt. The contributing partner would assume that the debt would be paid by the new entity out of operating income.
New Treasury Regulations adversely affect both contributions to a partnership subject to an existing full recourse debt and transactions pursuant to which the entity classified as a partnership distributes the proceeds of a new debt to a contributing member.
IRC §707(a)(2)(B) distinguishes between (a) contributions of property by the partner to the partnership and the distribution of money or other consideration to the partner by the partnership, and (b) “disguised sales” of property by the partner to the partnership. In the former case, the two steps may take place without adverse tax consequences. In contrast, in the case of a disguised sale, the transfer and the distribution are treated as though the partner sold the assets to the partnership thereby recognizing taxable gain or loss.
Generally, a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner will be treated as a “disguised sale” of property by the partner to the partnership (and, therefore, the cash or other consideration received may be taxable to the partner) if, based on all facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property, and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.
Under existing regulations, distributions funded with a partnership full recourse debt that are made to a partner who transferred property to a partnership may be excluded from the disguised sale rules by the contributing partner guaranteeing the debt. A debt financed distribution is not a disguised sale where the partnership incurs a liability and the proceeds of this liability are traceable to the transfer of money to a contributing partner but only to the extent that the amount of money does not exceed the partner’s share of partnership liabilities. To the extent a partner receives a distribution of debt financed proceeds that is not allocable to the partnership liabilities, the disguised sale rules will apply.
Under new temporary regulations, the partner’s share of a partnership liability for disguised sale purposes is the same percentage used in determining the partner’s share of non-recourse liabilities. The partner’s share of such liability is determined by the contributing partner’s share of profits. This new rule applies regardless of whether the liability is recourse or non-recourse or the partner guarantees the liability. In the case where a partner contributes assets to a partnership and the partnership borrows new money to make a distribution to the contributing partner, the contributing partner cannot be allocated all of the debt. The contributing partner can only be allocated debt equal to his percentage share of profits. This generally means that a disguised sale treatment will apply.
This new rule on how a partner shares full recourse liabilities is equally applicable to the situation where a partner contributes assets subject to liabilities, except in the instance where the liabilities are “qualified liabilities”. For example, under prior regulations a person who owns a valuable asset could not take out a new full recourse mortgage on the property and then contribute the property subject to the full recourse mortgage and avoid the disguised sale rules by remaining the sole guarantor of the debt. Under the new Treasury Regulations, the mortgage would have to be outstanding for sufficient number of years to become a “qualified liability”.
To help mitigate the impact of the new rule, the definition of a qualified liability has been expanded to include a liability incurred in connection with a trade or business in which the property transferred to the partnership was used or held if
all the assets relating to that trade or business are transferred to the entity classified as a partnership.